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Archive for January, 2011


More Evidence on the Damage Caused by SOX

Professor Stephen Bainbridge of UCLA law school has written a paper entitled “Corporate Governance and U.S. Capital Market Competiveness.”   Professor Bainbridge clearly shows that U.S. corporate governance is not the problem, regulation is.  The paper shows “that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis.”  The effectiveness of this corporate governance is never evaluated after it is passed.  A number of econometric studies have shown that investors have not profited at all from securities regulation.[1] The article clearly shows that “U.S. capital markets steadily became less competitive globally throughout the decade.”  This is consistent with the analysis in my book, The Decline and Fall of the American Entrepreneur.

Startlingly, the article shows,

In the 1990s, the number of foreign issuers listed on the NYSE roughly quadrupled, with NASDAQ experiencing similar growth, while London and the other major European exchanges were losing market share. Since 2000, however, the situation appears to have reversed. Using global IPOs as an indicator of the relative competitiveness of capital markets, for example, there was a dramatic decline in the U.S.’ market share 48% to 8% between 2000 and 2006.

This change was clearly due to changes in the regulatory environment in this decade.

U.S. corporate governance regime was well above average in the global picture. Even when the fallout from the bubble (technology bubble) was taken into account, returns on the U.S. stock market equaled or exceeded those of its global competitors during five time periods going back as far as 1982. Likewise, U.S. productivity exceeded that of its major Western competitors. In general, the trend with respect to major corporate governance practices had been towards enhanced management efficiency and accountability. Pay for performance compensation schemes, takeovers, restructurings, increased reliance on independent directors, and improved board of director processes all tended to more effectively align management and shareholder interests. (Emphasis Added)

According to the article “SOX is viewed both domestically and internationally as stifling innovation.”  It also shows that the cost of SOX was order of magnitude greater than originally estimated.

The SEC estimated that the average cost of complying with § 404 would be approximately $91,000.36 In fact, however, a 2005 survey put the direct cost of complying with § 404 in its first year at $7.3 million for large accelerated filers and $1.5 million for accelerated filers. “First-year implementation costs for larger companies were thus eighty times greater than the SEC had estimated, and sixteen times greater than estimated for smaller companies.”

So how has this affected public companies financials?

Both the recurring nature and disproportionate impact of these costs is confirmed by a recent study of the impact SOX had on the operating profitability of a sample of 1428 firms. Average cash flows declined by 1.3% post-SOX. Costs ranged from $6 million for small firms to $ 39 million for large firms. These costs were not limited to one-time first year implementation expenses. Instead, substantial costs and reduced profits recurred throughout the four year study period. In the aggregate, the sample firms lost about $75 billion over that period.

SOX has also had a major impact on venture capital and technology startups.

Start-up companies opted for financing from private-equity firms, rather than using an IPO to raise money from the capital markets. Because going public is an important venture capital exit strategy, partially closing the exit could impede start-up financing, and therefore make it harder to get ideas off the ground.

I have shown in my book that the inability to go public has had a significant deleterious effect on technology startup companies.

The evidence that SOX and the new financial reform bill are damaging our economy and not provided any of the promised benefits is overwhelming.  However, it appears that the short term political advantage is outweighing the interests of the country.


[1] Liu, Tung, Santoni, Gary J., Stone, Courtenay C.,   Federal Securities Regulations and Stock Market Returns.  This paper surveys several papers that have studied the effects of securities laws all of which show no meaningful change in investor outcomes.

 

 
Obama:Crony Capitalism Will Create Jobs

President Obama must be playing a practical joke on the American people by  his appointment of Jeffery Immelt, CEO of General Electric, to his economic team heading the new Council on Jobs and Competitiveness.  Since Immelt became CEO of GE in 2001, “GE has shed 34,000 jobs in the U.S., according to its most recent annual filing with the Securities and Exchange Commission.”[1] Why would you appoint someone to advise on job creation who has not created a job in 10 years?! Whose company would be bankrupt but for a government bailout?!  Perhaps this appointment is quid pro quo for Immelt’s MSNBC being the propaganda arm of the Obama administration.  How can a CEO who’s only skill is crony capitalism, the ability to milk the government for money and favors, help our economy?  Jeffery Immelt has proven a bad CEO for investors also.

The stock, which was $40 and change when Immelt took over, has collapsed to around $16. Even if you include dividends, investors are still down about 40%. In real post-inflation terms, stockholders have lost about half their money.”[2] In addition, GE is a member of the Coalition for Patent Fairness, a group advocating weakening our patent system.  If President Obama was serious about creating jobs and strengthening our economy, he would have appointed someone who had created new businesses.  According to the Kaufmann Foundation, all net new jobs “new firms add an average of 3 million jobs in their first year, while older companies lose 1 million jobs annually.”  The study covered 1977 to 2005.[3] According to the SBA, small businesses:

Represent 99.7 percent of all employer firms.

  • Employ just over half of all private sector employees.
  • Pay 44 percent of total U.S. private payroll.
  • Have generated 64 percent of net new jobs over the past 15 years.
  • Create more than half of the nonfarm private gross domestic product (GDP).
  • Hire 40 percent of high tech workers (such as scientists, engineers, and computer programmers).
  • Made up 97.3 percent of all identified exporters and produced 30.2 percent of the known export value in FY 2007.
  • Produce 13 times more patents per employee than large patenting firms; these patents are twice as likely as large firm patents to be among the one percent most cited.

President Obama is playing cruel joke on the American people by appointing Immelt as a top economic advisor.  Mr. Immelt’s only real skills seem to be political.

 

 
Larry Kudlow: Chinese Economy Relies of Stealing US Intellectual Property

Larry Kudlow in an article titled How to Combat an Arrogant China, suggests that China’s economy is based on the theft of our intellectual property.

They’re stealing our technology, violating all sorts of patent-protection laws, hacking into Google and infringing on intellectual-property rights. In fact, 80 percent of Chinese software is reportedly pirated from American companies.

It is great to see Mr. Kudlow wake up to the value of intellectual property.  Unfortunately, he seems to imply that enforcing intellectual property is not consistent with free trade.

As a strong free-trader myself, I recognize the many benefits free and open trade offers both China and the United States. But like many others, my free-trade patience with China is wearing thin.

If China stole its raw materials from the US, would it be a violation of free trade to then to demand that China pay for its raw materials?  The single most important raw material that China uses to produce it products is intellectual property.

It is nice to see the Larry Kudlow is beginning to wake up to the importance of intellectual property particularly patents.  Note that the US spent a lot of political capital in the 90s to get a mechanism to force other countries to strengthen their intellectual property as part of the TRIPs treaty.  But no president has had the courage to actually use the mechanism to force other countries to live up to their agreements.[1] Perhaps this is because every president since Reagan has been ambivalent about patents at best.  Only Hollywood and the software industry’s copyrights are able to get the attention of Washington.  However, patents are much more important to the US’s economic future.

Perhaps now that Mr. Kudlow has woken up to the fact that the economy is driven by more than Wall Street, tax rates, and the money supply, he will help advance some initiatives that will strengthen patent laws both here an abroad for American inventors.  Here is a short list of suggestions

1) Patent Reciprocity:  If you drive your car across the border into Canada you do not lose title to your car.  If you take your manuscript across the border into Canada you do not lose the copyright to your manuscript.  But, if you take your invention across the border into Canada, you lose your patent protection and anyone can steal the invention – not the physical embodiment, but the underlying invention.

Patent reciprocity would automatically provide patent rights in a foreign country when you obtained a patent in the US and vice versa.  This idea was first proposed by the US in the mid 1800s according to B. Zorina Kahn’s book “The Democratization of Invention: Patents and Copyrights in American Economic Development, 1790-1920”. Unfortunately, the idea died and since then patent rights have been part of the convoluted process of trade negotiations.

Patent reciprocity would significantly increase the value of patents and increase the value of research and development.  As a result, it would spur investment in innovation.  Reciprocity would increase the valuation of technology start-up companies in all countries that participated.  It would also increase per capita income.

 

2) Repeal the Publication Requirement: This would restore the social contract

3) Repay PTO:  Congress should repay the over $1B it stole from inventors with interest.

4) Repeal KSR: A subject standard of patentability just increases costs and uncertainty associated with the patent process.  KSR makes bureaucrats the ultimate arbiter of what is patentable instead of logic.

5) Repeal eBay:  This decision is logical absurdity.  If a patent gives you the right to exclude, then if you win a patent infringement case you must be able to enforce your only right – the right to exclude

6) Eliminate “Combination of Known Elements”:  The fact that the Supreme Court does not understand that every invention in the history of the world is a combination of known elements is pinnacle of ignorance.  Have they ever heard of “conservation of matter and energy”?

 


[1] Pat Choate has documented this issue extensively

 

 
Obama: Make Regulation Efficient

President Obama in a Wall Street Journal op-ed piece said that he has directed federal agencies to eliminate job killing regulations.  According to Obama the Executive order requires “a government-wide review of the rules already on the books to remove outdated regulations that stifle job creation and make our economy less competitive.”  As an example he points out:

For instance, the FDA has long considered saccharin, the artificial sweetener, safe for people to consume. Yet for years, the EPA made companies treat saccharin like other dangerous chemicals. Well, if it goes in your coffee, it is not hazardous waste. The EPA wisely eliminated this rule last month.

The fact that it has taken a severe economic recession and the lagging poll numbers of a president to make this changes shows how heavy handed our government has become and how Bzyantine our regulatory environment is.  I have suggested that the US needs a Regulatory Bill of Rights to provide citizens protections from excessive and contradictory regulations.  The Bill of Rights (first ten amendments) do not protect citizens from regulatory rules.  With just a few exceptions, if the governmental designates something a regulatory law or civil penalty then it can completely ignore the Bill of Rights.  I doubt that this is what the Founding Fathers intended when they passed the Bill of Rights.

 

If President Obama really wants to get rid of job killing regulations here is a list in order of importance:

1) Repeal Sarbanes Oxley

Sarbanes Oxley has effectively killed the IPO market and the better part of the equity market in the US.  See Sarbane Oxley Obstructing Innovation

2) Fully Fund the US Patent Office

Congress has stolen about $2B in user fees from the US Patent Office over the last two decades.  This has hurt innovation, job growth, and the economy.  See Restore Patent Funding to Create Jobs.

3) Repeal all Securities Laws

Every econometric study of our securities laws shows that they provide no benefit for investors.  See Liu, Tung, Santoni, Gary J., Stone, Courtenay C.,   Federal Securities Regulations and Stock Market Returns. This paper surveys several papers that have studied the effects of securities laws all of which show no meaningful change in investor outcomes.

4) Pass a Regulatory Bill of Rights

This would provide ordinary citizens the tools necessary to require the federal government to only implement regulations that achieve their purpose in a cost efficient manner.  See Regulatory Bill of Rights.

 

5) Eliminate the Income Tax

The income tax is not designed to generate revenue for the federal government.  It is designed to punish certain people who have committed no crime (violation of the due process clause of the 5th Amendment) and to allow Senators, Congressmen and the President to sell tax favors to the wealthy.  The income tax system should be replaced with a system with the sole goal of providing the federal government the revenue it needs.  A flat tax or a national sale tax would both work.

 

6) Repeal ObamaCare

This is a job killing piece of legislation that we cannot afford.

 

7) Reform Social Security and Medicare

The best reform is to make them defined contribution programs instead of defined benefit programs.

 

If President Obama were to implement these five simple changes, the U.S. would see above 7% growth for the next two decades.

 

 
George Will: US Suffering From Innovation Dearth

In a January 2, 2011 column (Needed: A science stimulus) in the Washington Post, George Will points out that the US is suffering from a lack of innovation.  He makes a token node to the patent system in the article and then he focuses on government spending on science and engineering and does not mention the patent office is underfunded.  George reflects Washingtons and the elitists attitude that government spending is what drives the economy.  He just believes government spending should be directed to science.  In addition, he repeats the elitist comment that most of the science is done by the elite and us peasants don’t really contribute much.

The late Nobel laureate Julius Axelrod said, “Ninety-nine percent of the discoveries are made by 1 percent of the scientists.”

This elitist attitude contradicts all the available evidence.  As the book, The Most Powerful Idea in the World, discussed in Georges’ article points out, sustained economic growth does not happen until property rights for ideas (patents) are enacted.  This releases a flood of inventions, not by the elite, but by ordinary citizens.  It was the democratization of the inventing process that lifted the masses out of the Malthusian Trap.

 

 
Repeal of Financial Reform?

Michele Bachmann has introduced a bill repeal the massive and widely criticized Dodd-Frank financial (see Newsmax story and Stillwater Gazette story).  This is a good first step, but she should have also included the repeal of Sarbanes Oxley.  Ms. Bachmann has correctly criticized SOX as ineffective and overly expensive.

When Sarbanes Oxley was passed, the SEC (Securities and Exchange Commission) estimated the cost of compliance would be $91,000.00 per year for each public company.  The most recent estimates for the cost of compliance are between $4.0 million and $5.0 million per year for publicly traded companies.  This clearly has an affect on the number of IPOs.

Is the cost of this law worth its incredible price? Has Sarbanes Oxley achieved its goal of protecting investors from fraud?  Sarbanes Oxley has cost the U.S. economy at least $400 billion since it passage.  This is just the direct costs and does not include the opportunity costs, which are most likely substantially higher.  The stock market has been flat or declining since its passage.  As a result, it is hard to argue that this legislation increased shareholder value.  The banking scandals of 2008 & 2009 that included Bear Sterns, Lehman Brothers, American International Group (AIG), Merrill Lynch, and the Bernie Madoff fraud make it impossible to suggest that Sarbanes Oxley has protected investors from fraud.

 

 
CAFC Appointments

According to IPWATCHDOG President Obama has renominated Edward C. DuMont and Jimmie Reyna to serve on the United States Court of Appeals for the Federal Circuit.  Neither of them are patent attorneys.  As I pointed out in my post Makeup of the CAFC, the number of patent attorneys on the court has been shrinking since its creation.  Neither DuMont or Reyna have a technical background.  Patent law requires both an understanding of the underlying technologies involved and an understanding of the law.  We have seen consistently bad decisions out of the Supreme Court and CAFC because they do not understand the underlying technologies.  It takes a number of years to understand patent law, it is not like other areas of the law.  For instance, most judges do not understand the very basic concept that all inventions are combinations of existing elements.  They do not understand that this follows from conservation of matter and energy.  It is not a legal concept it is fundamental principle of reality.  We need patent attorneys with strong technical backgrounds on the CAFC, if we are going to have a well function patent system in the US.

 

 

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